The course weblog for PA5113, State and Local Public Finance, at University of Minnesota

Friday, February 27, 2009

Why Broadening the Sales Tax May Reduce Future State Budget Swings

During the past ten years, Minnesota's budget has swung wildly between periods of feast and famine. In 1999, the long-term budget looked so rosy, that we provided significant tax cuts and tax rebates to Minnesotans. Just four years later, the state of Minnesota faced a $4.2 billion budget deficit, and engaged in soem of the biggest cuts to state government in recent decades: cuts that disproportionately hurt low-income and disabled Minnesotans. After roughly five years of general budget solvency, the economic downturn of 2008 again generated more bad news for the state, with significant (and growing) budget deficits projected for for the next two budget biennia.

How does this happen? And how is it relevant to the sales tax? The structure of the State of Minnesota’s revenue sources make it particularly vulnerable to changes in the economic climate. In fact, a recent Budget Trends Study Commission Report finds that Minnesota’s revenue stream is only getting more volatile over time. This is, in part, a result of Minnesota’s more progressive revenue system. Minnesota generates 48% of its general fund revenue from the state income tax, a very progressive, but also volatile tax (see graph). That is, when times are good, Minnesota generates a LOT of revenue. When times are bad, people make less money, pay fewer income taxes, and the state ends up in a mess.

Correspondingly, the state’s general fund revenue base relies less heavily on more stable forms of revenue, like the sales tax. This is, in part, because Minnesota hasn’t historically relied on regressive taxes like the sales tax, exempting things like food, clothing, and medical costs from taxation. However, this lower reliance on sales tax revenue is also due to the US economy’s shift from a manufacturing base to a service base, reducing the number of transactions subject to sales tax and, over time, eroding the adequacy of Minnesota’s sales tax revenue (from 33.3% of general fund revenues in 1970 to 28.5% in 2006).

In part as a result of this combination of circumstances, budget-related panels appointed by Governor Pawlenty and the legislature, as well as some think tanks (both local and national) have suggested a switch from the current, narrow sales tax structure, to a new, broader structure that taxes more goods and services at a lower rate. By expanding the sales tax to include more services and potentially, more goods (such as food and clothing), we could both reduce the overall rate of sales tax while helping to stabilize Minnesota’s general fund revenue sources. While some may argue that this increases the regressivity of Minnesota’s revenue system, it also stabilizes the state budget, thus better ensuring the long-term sustainability of state programs that assist low-income and vulnerable Minnesotans.